Congressional Tax Bills: Keynes on his Head

While the proposed tax bills will have a significant impact upon your
personal budget, it will also have potentially important effects on the
economy as a whole.

At the end of last week, the House of Representatives and the Senate
each passed different versions of a tax reduction bill. Today Clinton threw
a third option into the mix. The job now is to reconcile the two bills
with one another and negotiate with the Clinton Administration to try to
create a bill acceptable to all three. Clearly, the resulting bill will
include some tax cuts, most likely something between the Senate’s $85 billion
cut and the House’s $135 billion cut. The cuts come mostly from a $500
per child tax credit and a reduction in the capital gains tax (although
this component is potentially grounds for a veto).

What’s wrong with this picture: the economy is doing
well and Congress passes a tax cut? But wait, whatever happened tocounter-cyclical policy? Keynesian economics suggests that to stabilize
the economy we should raise taxes and/or lower spending in booms, and do
the opposite in recessions. Theoretically, not only will this help to lessen
the troughs and level the peaks, but it will also lead to a budget that
is balanced on average over time – deficits in recessions, surpluses in
booms. The Congress and the President seem to be heading in the opposite
direction.

Two theories

First: The tax reduction need not fly in the face of responsible fiscal
policy. It could be the case that the economy is doing well now, and is
forecasted to do very well in the future. The permanent level of taxation
thus could then be lower than it is currently (since the social support
demands on the system are lower and the government is taking in more revenue
through higher incomes). In this way, reducing taxes now is a way of adjusting
to a new economic environment in which the desired level of federal spending
is reduced.

Second: If we look to politics as a guide, the Congress seems to be
behaving as if there were an implicit Balanced Budget Amendment (with a
no-surplus provision). If we were to take the current bill and remove the
tax reduction components, the deficit would fall by the $85 billion, thus
creating a surplus by the year 2002. Congress, however, seems to have an
incentive to splurge on the extra cash generated by the booming economy
reduce taxes – bringing the deficit to exactly zero. The destabilizing
anti-Keynesian effects of a Balanced
Budget Amendment are well known.

Where have all the Hawks gone?

With the economy doing well, it seems like almost an easy task to balance
the budget. When we extend that rosy forecast in to the future, the booming
economy naturally raises the amount of income received through taxes and
reduces the demand on social support programs.

But what of an economic downturn? Unless economy is expected to continue
on its current path into the indefinite future, deficit Hawks should be
squawking for a projected surplus down the road.

While Congress is standing Keynes on his head, the Fed can play the
monetary policy trump card. Many have written off active fiscal policy
as a tool for counter-cyclical policy. This conclusion followed from an
acknowledgment that the politics of fiscal policy formation usually create
too much of a lag between the need for fiscal action the enactment of law.
The Fed, however, is largely immune from the typical political delay, and
the effect of policy actions take place in a (relatively) timely manner.

So if the Congress is ignoring Keynes, perhaps they are doing so for
a good reason. A third theory: the fed may simply be neutralizing the economic
effects of fiscal policy, relieving Congress of the job of managing the
macroeconomy.

The loudspeaker at the Capital announces:

Keynes has left the building.

Keynes has left the building.

See Also:

Here’s a quick look at the state of the economy: GDP growth at 5.9%,
unemployment at 4.8%, corporate profits up 6.3%, Even though some believe
that the economy may be slowing on its own, (Housing starts down 5%, durable
goods orders down 0.6%), it’s still doing pretty well. See the Economic
Statistics Briefing Room for more.

Sidebar #2: The Politics of Capital Gains: A
primer.

Issue: The Senate bill proposes a reduction in the capital
gains tax from 28% to 20%

The majority of the benefits
would go to households making between $20,000 and $75,000 a year.

Both are right. Each super-richindividual will make out very well (saving $80,000 on every
million in realized cap gains). However, there are more families in the
lower tax brackets meaning that as a group they will receive the
bulk of the benefits.

Growth

Higher growth is not necessarily shared by
everyone (like in the 1980’s).

See Distribution (I)

A reduction would mean more savings and higher
growth for the economy.

(Dems) Even though not everyone
gains from economic growth – most are hurt by a stagnate economy.

(Reps) By all serious accounts the growth effects are very small. To
the extent that it adds to the deficit it may hurt
growth.

(Both) Alan Greenspan – a.k.a. the “gate-keeper of economic growth”
– needs to be consulted about the possibility of higher growth.